It Pays to Look Forward

By David Waddell

The thundering herd that carried the equity markets into the record books in 2013 seemed spooked by the first few trading days of 2014. Should we read into this?

Perhaps, but it more likely indicates portfolio rebalancing rather than a widespread repositioning of wagers. Those rebalancing their portfolios need to sell stocks to provide currency to replenish underperforming asset classes. For those that shifting wagers, what new bets might pay off in 2014?

Further afield, the emerging markets, which rely heavily on commodities exports, actually fell 5 percent overall. Those who held the inflation trade in 2013 simply missed the boat.

The silver lining for 2013’s inflation-sensitive losers lies with their compelling valuations entering 2014. Energy and materials shares trade below broad market valuations, and the emerging market complex trades at a 30 to 50 percent discount to the U.S. market. Russia, for instance, heavy with commodities, trades for 4.8 times forward earnings. Yes, I know you are thinking, “Why would I ever invest in Russia?” For the same reason you should have invested in Greece. Greece may be today’s economic laughing stock, but off of sub-5 times valuation at the start of last year, Greek stocks advanced 53 percent.

If you believe that global economic growth will accelerate in 2014, then perhaps rising inflation will ascend the list of investor concerns in 2014. Since markets tend to look 6 to 12 months into the future, maybe inflation in 2015 will influence successful investment strategies in 2014.

Fortunately, we do know how the future will unfold. Government assisted economic growth will transition to unassisted economic growth. As growth absorbs slack within the economy, price pressures will build. Vigilant about runaway inflation risks, the Fed will overreact through over-tightening monetary policy, resulting in economic recession and market declines.

This is the normal course of the business cycle. What we don’t know is the timing. If everything fit neatly into 12-month intervals, we could extrapolate that the 2013 stock market rally foresaw accelerating economic growth in 2014. In 2014, inflation sensitive issues would foresee rising price levels in 2015, and in 2015 the stock market would anticipate recession in 2016. Invest accordingly.

Bottom line: As strategists formulate narratives for 2014, listen for talk of durable economic growth inciting inflation concerns. Markets do not like inflation talk, but with economic growth and earnings rising overall this is not necessarily something to fear.

Additionally, there are undervalued corners of the market that should benefit from rising inflation chatter. Sizable money flows create sizable returns when strategists change consensus. It’s too early to tell whether we are seeing a consensus shift back toward inflation protection, but it pays to look forward.

David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.